Question

CA18-6 (Recognition of Revenue from Subscriptions) Cutting Edge is a monthly magazine that has been on the market for 18 months. It currently has a circulation of 1.4 million copies. Negotiations are underway to obtain a bank loan in order to update the magazine’s facilities. Cutting Edge is producing close to capacity and expects to grow at an average of 20% per year over the next 3 years.

After reviewing the financial statements of Cutting Edge, Andy Rich, the bank loan officer, had indicated that a loan could be offered to Cutting Edge only if it could increase its current ratio and decrease its debt to equity ratio to a specified level. Jonathan Embry, the marketing manager of Cutting Edge, has devised a plan to meet these requirements. Embry indicates that an advertising campaign can be initiated to immediately increase circulation. The potential customers would be contacted after the purchase of another magazine’s mailing list. The campaign would include:

1. An offer to subscribe to Cutting Edge at three-fourths the normal price.

2. A special offer to all new subscribers to receive the most current world atlas whenever requested at a guaranteed price of $2.

3. An unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine.

Although the offer of a full refund is risky, Embry claims that few people will ask for a refund after receiving half of their subscription issues. Embry notes that other magazine companies have tried this sales promotion technique and experienced great success. Their average cancellation rate was 25%. On average, each company increased its initial circulation threefold and in the long run increased circulation to twice that which existed before the promotion. In addition, 60% of the new subscribers are expected to take advantage of the atlas premium. Embry feels confident that the increased subscriptions from the advertising campaign will increase the current ratio and decrease the debt to equity ratio.

You are the controller of Cutting Edge and must give your opinion of the proposed plan.

Instructions

Does the proposed plan achieve the goals of increasing the current ratio and decreasing the debt to equity ratio?

Short answer

The proposed plan will not increase the current ratio and will also not decrease the debt-equity ratio.

Step-by-step solution

Definition of Debt-to-Equity Ratio

The ratio calculated for evaluation of the financial leverage of the company is known as the debt-to-equity ratio. This ratio is calculated using the business entity's total liabilities and total equity.

Propose Plan

The proposal will not increase the current ratio because the sale of subscriptions will increase the current assets. An increase in unearned revenue will increase the current liability by the same amount. Therefore, the current ratio will remain unaffected. Additionally,estimated premium claims outstanding will increase the current liability, which will reduce the current ratio.

Debt to equity ratio will also not decrease because of the increase in the current liabilities.

Note: These ratios will improve on recognition of revenue.